Fed seems willing to gamble on short-run trade-off

Economists may not see eye to eye on much, but over the years I’ve found a few core concepts on which all but the most politically motivated would agree.
One is that inflation is a monetary phenomenon – “always and everywhere,” to quote the late Nobel laureate Milton Friedman. Another is that there is no long-term trade-off between inflation and unemployment, a relationship expressed by the Phillips Curve.
Friedman, again, along with fellow Nobel laureate Edmund Phelps, argued that any attempt to push employment below a so- called “natural rate” would backfire when workers realized the higher wages offered them were a “money illusion” and prices were rising even faster. Their augmented Phillips Curve became the accepted way to explain the coexistence of high inflation and high unemployment in the 1970s.
So why would the Federal Reserve be willing to risk higher inflation for, at best, a short-run boost to employment? The simple answer is that some policymakers don’t see it as a risk. Today’s 9.1 percent unemployment rate is well-above what’s considered full employment in the U.S., giving the Fed leeway to advance one of its dual mandates (maximum employment) without compromising the other (stable prices).
Fed governors Daniel Tarullo and Janet Yellen are already on record as ready or willing to expand the Fed’s $2.86 trillion balance sheet. And if they can help the housing market in the process – print money to buy mortgage-backed securities – so much the better!
Not everyone is so sanguine about further stimulus. Three Fed District Bank presidents dissented at the last two meetings, opposing August’s pledge to keep the funds rate near zero through mid-2013 and the decision in September to extend the maturity of the Fed’s securities portfolio.
Members of the Shadow Open Market Committee, a group of independent economists who meet twice a year to evaluate the Fed’s policy choices, are similarly inclined.
Tarullo and Yellen, as mentioned above, are in the “risk” camp. They look at measures of excess slack in the economy – things like the rates of unemployment and capacity utilization – and conclude there’s room for further stimulus. Curiously, the quasi-monetarists, who advocate maintaining a constant level of nominal gross domestic product, think the Fed should embark on additional asset purchases as well. Some respected economists, including Harvard’s Ken Rogoff and the International Monetary Fund’s Oliver Blanchard, are in the “target” camp. In their view, higher inflation would help the deleveraging process by allowing debtors to pay back their loans in devalued dollars. (Savers get hosed.)
“The silent majority of economists,” Goodfriend said. They don’t see inflation as a real risk, and if they’re wrong, the attitude is that the Fed can always deal with it later.
Later has consequences. The lesson of the 1970s is that any short-run employment benefits from tolerating higher inflation today, which are “questionable,” create adverse long-term effects, requiring tighter monetary policy, he said.
Policymakers rely on econometric models to forecast things like GDP growth, inflation and the output gap, a squishy concept that’s supposed to reflect the difference between actual and potential GDP. It’s the perceived output gap – and particularly excess supply of labor – that has some Fed officials willing to restart the printing press.
Goodfriend says inflation is indicative of the size of the output gap. And inflation isn’t falling.
It used to be an article of faith among central bankers that price stability is both an end in itself and the means to an end: maximum employment. Fed chief Ben Bernanke has said as much.
With the Fed under tremendous pressure – implicit, not explicit – to do something, anything, to help a floundering economy, Bernanke saw fit to remind Congress of the limits of the central bank’s powers.
“Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy,” Bernanke said Oct. 4 in prepared testimony to the Joint Economic Committee of Congress.
That would make a good wall poster for the boardroom where Fed officials meet this week to discuss policy options. &#8226


Caroline Baum is a Bloomberg News columnist.

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